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Wednesday, December 31, 2008

Seize the moment

P. S. Subramanyam had an opportunity where the true NAV of US-64 was above the administered buying/selling prices of UTI. At this point, he could have easily transitioned into NAV-based pricing. He blew this opportunity, and we all know what happened after that.

Writing in Business Standard, A. K. Bhattacharya says that India should seize the moment, where petroleum product prices are actually below the administered prices, and shift to market pricing.

Tuesday, December 30, 2008

Crisis watch, 30 December

TED spread 1.45
S&P 500 returns -0.39%
VIX 43.9
Nikkei 225 (9:16 AM IST) +1.28%
US Financials index -1.37%
ICICI Bank ADR +8.94%
Call rate on 29th 5.21%
Currency futures (9:16 AM IST)48.7375
  • Deepak Lal in Business Standard on how to head off protectionism.
  • Jayanth Varma on how recent events should change the way in which we teach finance.
  • Rama Bijapurkar reminds us that some firms have low betas, in Financial Express.
  • Paul Kattuman, in Financial Express says that wage flexibility is the best kind of adjustment to a downturn.
  • Eric Lipton and David D. Kirkpatrick in the New York Times on finding profits in the downturn.

Monday, December 29, 2008

Karachi's experiments with circuit breakers in 2008

by Junaid Khalid, MCB Asset Management Company Ltd.

In a world where volatility skyrocketed while stock markets fell, the Pakistani market volatility held its ground, and diminished to near-zero. A floor on prices ensured that there were no defaults.

The country's obsession with the stock market in the past lead all to believe that it was by far the most important economic indicator. Pakistan's cricket team was once the most talked about asset, but when that started falling apart, the focus shifted to the buoyant stock market index. Poverty, inflation and currency depreciation were all pushed aside and the glorious KSE-100 index embedded itself firmly in every dentist, driver, grandparent and banker's mind. Everyone could play, and all that was required to win a fancy car was riding the bull run with `CFS' (badla) on your side. In India, badla trading ended in 2001, and was replaced by a world of rolling settlement accompanied with derivatives trading. Pakistan has not crossed that hump.

With a rapidly rising market, the KSE managed to pull a fair amount of foreign investors chasing annualised returns in excess of two hundred percent. The mighty greenback started flowing in and the benchmark KSE-100 index reached highs above the fifteen thousand level. Then trouble began when, between April and June 2008, the index fell by around 4500 points. The regulator, in consultation with brokers panicking about the lower 5% circuit breakers being hit continuously, decided to change circuit breakers from their -5 to +5 per cent range to a -1 to +10 per cent range on June 23rd, 2008. This was an asymmetric system of circuit breakers: prices could go down only 1% but they could go up 10%.

The regulator and the KSE administrators were not being price-agnostic; they were trying to force a direction on the index. One goal was to give brokers some time to meet mark to market requirements by selling illiquid assets such as property. Short selling was banned and the market jumped up the next day by 960 points as the shorts covered their positions and the newspapers read 'Stocks on a high after new rule drowns small fry'. This announcement was also treated with suspicion because it came on Tuesday, one day after investors had just rolled over positions from the one month June expiration contract to the new July contract. Small brokers questioned the short sale, saying "If at all the ban were to be imposed, the announcement could have come on Saturday, so that those who entered on Monday were not trapped."

The market, which had recorded a fall of 4,500 points over two months from April 18 to May 23 showed a six per cent increase in the 10 sessions following these 'stabilisation measures'. "Nothing could have been more satisfying to regulators and investors, but that the artificial planks put under the market fall had started to crack," said an analyst. Investors started realising that a market could not artificially be given a direction and if trades had to occur, a 1% lower breaker would only delay the fall in prices. All too often, the circuit breaker was hit and trading stopped because buyers and sellers refused to transact at the price permitted on the screen. Circuit breakers converted price risk into liquidity risk. Average daily volumes fell to 10-year lows to around 20 million shares a day, from last year's daily average of 240 million shares. Brokers started feeling the consequences of the SECP decision as their volume driven income depleted.

The brokers and SECP embarked on a set of meetings to discuss how to build a 30 billion rupee fund to 'stabilise' the market.

On July 11th 2008, in a meeting held on Friday among the chairman of the SECP, Islamabad, Karachi and Lahore Stock Exchanges, the efforts of the SECP to stabilize the market were applauded but highlighted as 'temporary'. The meeting concluded that circuit breakers needed to be restored to their original -5 to +5 per cent range, and short selling was allowed again. In addition to these, the Equity Market Opportunity Fund was discussed again, and a harsh warning was given about blank selling and market manipulation.

The market quickly took a nosedive in 5% decrements which lead to widespread panic as the possibility of defaults on badla positions became imminent.

On 27th August 2008, the board of directors of the Karachi Stock Exchange decided to place a floor based on the closing prices of securities on Wednesday August 27th 2008. On this date, the KSE-100 index was around the 9000 level. It ended its press release with a promise to engage the SECP, the State Bank of Pakistan and the Ministry of Finance in efforts to achieve `stability'.

Since the date that this floor was imposed on the KSE index, trading volume essentially went to zero. Investors are questioning the wisdom of this stasis. In board meetings that followed, various different solutions to the crisis were discussed which included facilitating buy backs, reforming the badla system and providing liquidity and support. The size of the support fund that was discussed varied, and reached peaks as high as Rs.50 billion. Amongst the ideas discussed was a possible Rs.30 billion rupee put option with a maturity of 2 years to be sold to foreign investors by the government, so as to give them confidence to buy shares.

As the market index remained frozen, there was a run on mutual funds heavily invested in a mix of equities, badla financing, and fixed income. Redemptions were first met with cash reserves and then with proceeds from off-exchange transactions which rose in volume and started pricing shares approximately thirty five per cent below the closing prices of August 27th 2008. With increasing pressure of redemption, cries were heard from some asset management companies. In an emergency meeting with the mutual funds association on 6th October 2008, SECP decided to put a freeze on equity and equity related funds till the third day after removing the floor on the Karachi stock exchange index. While this ended pressure on equity fund redemptions, it destroyed the trust that investors had built up over years with mutual funds.

When this trust was lost, redemptions on fixed income funds rose sharply. People had had enough and feared the worst. As pay outs increased, the percentage of illiquid assets (mostly term finance certificates or `TFCs') started rising and most funds found it hard to meet redemptions. SECP did not freeze redemptions on fixed income funds. Funds went through a phase of delayed payments transitioning into an asset management company specific redemption freeze. On 5th November 2008 another circular was issued to mark down the value of all TFC's in the portfolio till 12th January 2008 (regardless of time to maturity) between 5% to 30% depending on their rating. The mutual fund investors who had loyally stayed invested, and not redeemed, now took a hit of up to 32% in one day. The idea of this mark down was to limit redemptions in fixed income funds.

With an ailing economy, Pakistan embarked on an IMF program. The government was forced to withdraw any mention of the market stabilisation fund to the Karachi stock market which was eagerly awaiting a bailout package. The IMF document read: "The government believes that market confidence will improve significantly once the fund-supported programme is approved and the international reserves position is strengthened. Therefore, it does not intend to remove the current floor on stock prices until after the programme is in place. In any event, the timing and terms under which the floor on stock prices will be removed, including any use of public funds to support the stock market, will be decided after reaching understandings with the fund staff." The IMF criticised the proposed Rs.50 billion government fund to buy shares, stating that it would create moral hazard.

The newspapers on 12 December 2008 read 'SECP tells three bourses to remove stock index floor on December 15th'. It should be mentioned that circuit breakers used to be based on the daily closing prices so on any given day a share could move five percent above or below the previous day's closing price. In the absence of liquidity the closing price would be the same as the opening price if there were no sellers or buyers so rules were amended to account for a situation where a stock could be allowed to bring down its trading range even in the absence of a liquid closing price. The Bid/Offer would be taken as the closing price provided that it stood for atleast two hours before closing.

With a two day weekend between the announcement and the day the floor would be removed, two securities firms obtained a stay order from the Sindh high court regarding their badla positions. The court issued notices to Karachi Stock Exchange and Securities and Exchange Commission of Pakistan for December 16 and in the meantime directed parties to maintain status quo. With hurried legal opinions from SECP and NCCPL it was decided on Sunday the 14th of December that 'As per Dec 11 SECP directives, the three local bourses are all set to resume trading on standard parameters (without floor rule) from Monday. The Continuous Funding System (CFS), however, would maintain a "status quo" only for two as per the SHC's Dec 13 ruling.' The newspapers further read that 'The heads of three institutions, the SECP, KSE and NCCPL, which are direct parties in the petition, held a marathon meeting here on Sunday to discuss the issue. The SHC stay order does not restrain the NCCPL (the manager of CFS(badla) market) from giving margin calls to the CFS participants other than the plaintiffs.'

And so the Karachi Stock Exchange finally removed its floor on Monday 15th December 2009 with the lower five percent breaker being hit repeatedly. At the time of submitting this article equilibrium had not been reached.

Comments to discuss, 29 December

A book, verily a book

Comment by Aftam Alam:


First I cursorily glanced through the content. I am now reading the book or shall I say chewing the book at my pace. Let me admit it meets my expectation 100%.

A little observation from me. I have always found you discussing ideas and institutions and never personalities. In this book, you have taken a departure and have given the list of architects of modern Indian financial system. By and large, I find it valid but I feel there are two notable omissions.

1. G V Ramakrishna for forcing acceptance of SEBI in the market. In the initial stages, "forcing" was the only course to create acceptability in the prevailing wayward market chaos.

2. D R Mehta for bringing market perspective into SEBI thinking. I can tell you this with conviction for I was an insider then. SEBI was and continues to be a cocktail of ignorance and arrogance. D R Mehta through committe approach and through informal line of communication with the market brought a sense of professionalim in SEBI policy making procedures. I also give D R mehta credit for hastening the introduction of derivatives. In his misplaced zeal for "Badla", he reversed G V Ramakrishna's decision and tried to give respectability to Badla system by commissioning a committee to document the features of badla system and policy prescriptions to safeguard its potential abuse. He wanted to give the badla system a semblence of respectability. The malfunctioning of this redesigned system made every one quickly realise that it was like putting a coat and hat on the top of a man who was wearing a tattered and dirty "dhoti". This definitely hastened the search for bonafide alternatives.

I rate their contributions superior to many in the list given in your book.

Goodbye great moderation, hello financial fraud?

Comment by Anonymous:

your prognosis has come true. SATYAM.

Crisis at Satyam

Comment by Basab Pradhan:

"share prices of both companies were in motion based on anticipation of these events prior to this"

Ajay, you went over this bit of your post unremarked. Why should there be "anticipation" of an event like this? Who were the people placing large blocks of trades in the run up to the announcement. Perhaps the answer to this seemingly irrational proposal, lies in what went down prior to the announcement.

Crisis watch, 29 December 2008

TED spread 1.41
S&P 500 returns +0.85%
VIX 43.38
Nikkei 225 (9:24 AM IST) -1.02%
US Financials index +0.23%
ICICI Bank ADR -4.38%
Call rate on 27th 5.772
Currency futures (9:24 AM IST)48.335
  • It looks like leverage by the promoter is an additional twist in the Satyam tale: See Hema Ramakrishnan in Economic Times.
  • An editorial in Financial Express on banking.
  • Bibek Debroy on India's responses to the slowdown.
  • Mahesh Vyas looks at firm level data in understanding the impact of the slowdown.
  • P. Vaidyanathan Iyer has a story about how the recent RBI easing came about.
  • An editorial in Financial Express on financial sector policy.
  • Shally Seth and Baiju Kalesh on defaults by truckers.
  • T. N. Ninan looks back at 2008 and says: can we please have better measurement?
  • Muthukumar K. has an article in Business World about buybacks. I think of it as a positive for the outlook for stock prices.
  • An editorial in the Financial Times about what is wrong with the G-20 process.
  • Paul Krugman's recent NYT column gives fresh insights into why public expenditure in India is not the answer to combating a downturn.
  • John Taylor has a devastating critique of the US Fed in the paper The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong.
  • Eduardo Porter in New York Times on ponzi schemes.
  • A fascinating story about recruitment abroad by Chinese financial firms. This reflects an opportunity for the firms left standing in these difficult times. There are already some signs of a flow back of people moving to India. What's interesting in this Chinese story is that the large Chinese firms seem to be actively recruiting in the US and elsewhere, and their targets include people of all nationalities.
  • Robert E. Lucas, Jr. on Bernanke's unorthodox approaches to monetary policy. The important new idea that I got here was that given a choice between (a) a central bank buying a variety of assets with credit risk in the economy vs. (b) direct fiscal activism, the former is a better way of doing counter-cyclical policy because it avoids the political economy difficulties of fiscal tools. And if I may add, it is easier for monetary policy to unwind these unusual interventions (just sell these assets) as opposed to getting unusual fiscal policy interventions to be unwound.
    You might like to also read this.

Thursday, December 25, 2008

How not to recruit a deputy governor at RBI

When I see malfunctioning organisations, all too often, the root cause lies in a bad HR process, or a weak set of mechanisms for hiring, firing, incentivising and training. In similar fashion, I think that the proximate source of bad governance in India is poor HR policies of government. Conversely, one of the most important elements of good governance is a well functioning appointments process.

By and large, the UPA has done a good job of recruitment. But I saw a paragraph today by Kumud Das in Financial Express about the recruitment of a deputy governor at RBI which struck me as being all wrong:

A ministry of finance source told FE on Wednesday that the search committee had met in New Delhi on Monday and reiterated the eligibility criterion laid down earlier for the position, which states that the incumbent must have served as chairman & managing director of a nationalised bank for at least two years.

If this is true, it is surely wrong. In these difficult times, we need the best man (or woman) for the job. This goal is hampered by narrowing the selection in this fashion. A meritocracy is one in which the best man for the job gets it, and there are no ifs and buts.

I can think of three outstanding candidates for this job, and none of them were ever chairman and managing director of a nationalised bank. Ruling out these three candidates from the appointments process for this job hinders the quality of the outcome.

Such recruitment policies damage the ability of RBI to grow into a top quality central bank. RBI should draw on the superior HR policies at SEBI as a role model: the recruitment of full-time board members at SEBI (which is equivalent to the deputy governor role at RBI) has no such quota system in the recruitment process.

What to do with the credit rating agencies

Read David Smick and Adam Posen on this subject.

Wednesday, December 24, 2008

The Image of India: Terrorised & Tarnished

by Percy Mistry.

9.30pm on 26-11-08 started sixty of the most ignominious hours for India. In that time its global reputation for competence disintegrated. TV screens around the world witnessed the unwinding of cumulative brand-building over fifteen years. India's image as a potential future super-power changed instantly to one of a brittle, incompetent, state. Sixty hours of mayhem, by just TEN semi-literate misfits, humiliated a nation of a billion in the eyes of the world. They underscored the dysfunctionality of a political establishment with misplaced priorities. They highlighted: (a) the lack of communication and coordination in our multi-layered system of government at city, state and central levels; (b) the confused, bureaucratic nature of our intelligence and security apparatus; and (c) the gross inadequacy of Indian forces of law and order to deal effectively with terrorism, despite its frightening frequency on our soil.

All our key agencies proved incapable. Yet many are now rewriting for posterity their roles with images of personal courage, sacrifice, 'martyrdom' and glory. Miles of footage and reams of prose make it redundant to repeat the trauma of those painful, insufferable hours. But much of it is now being criticised for revealing our public faults without air-brushing. The aftermath of 26/11 shows the deadly 'paralysis-cum-obfuscation-cum-foot-in-mouth' disease infecting our polity. Unfolding evidence suggests that central and state agencies had sufficient early warning, of sufficient specificity to be 'actionable', from a variety of internal and external sources, to take prophylactic action. Yet the state went into denial. The scale of the state's default in not performing its most basic duty - i.e. protecting its territory from attack and its citizens from harm -- is becoming clear. To its rulers, Indian lives are cheap. As Maharashtra's Home Minister, 'Dance-Bar' Patil succinctly put it: "small things happen in big towns"!

The anxiety of our government to divert attention from its failings led to immediate bellicose sabre-rattling against our perennially hostile, insecure, and even more incapable neighbour, to appease domestic outrage and baiting by the Opposition. Even if the ISI is behind this attack, our way of going about making the connection obvious to the world leaves much to be desired. We are being too shrill and indignant. Our ex-post handling of a still unfolding crisis could yet become a sub-continental tragedy, if we do not rise above ourselves to air our grievances more effectively, obtain redress, and protect India's interests over the long-term.

26/11 has revealed many things about India that we were content to obscure from ourselves but must now face frontally and do something about. First, we have to acknowledge openly that serving the Indian public could not be further from the minds of our political class. The statements made by satraps in every party after 26/11, prove that beyond reasonable doubt. Should they be taken at face value? Yes. Can they all be cases of misspeaking? They reflect a visceral contempt for us who are obviously seen as lumpen morons. We vote these sad excuses into office (despite their ignorance, malfeasance, self-enrichment and criminality) time after time. Thus we establish that we do not care for ourselves or how we are represented. They seem themselves as our masters (netas) rather than our servants (naukars). We collude in perpetuating that ridiculous notion; thus giving our democracy a particularly nasty twist.

Second, what comes across most clearly from 26/11, is how disconnected our political class is from us. It is apparent that, apart from undertaking the tedious task of seducing and bribing us at election time, our political class (with the exceptions being counted on two hands) exists to serve itself: i.e. to enrich, empower, indulge, protect and insulate itself from us; using the resources we provide but they command as their own. Our Treasury has become their piggy-bank. Our forces of law-and-order have become their vassals and servants used to serve their personal needs and political ends not ours. Our bureaucracy (endowed with some truly exceptional people who are badly used and abused) has become their machinery for their own political gain than for advancing our national interest.

Third, state-provided security of political megalomaniacs has become more important than the security provided to protect our lives. And, despite this tragedy, political goons at every level of government -- including those who go out of their way to destabilise our societies, divide and fracture us by accentuating ethnicity, caste and language, and open themselves to retaliation -- are surrounded by policemen putting themselves out of real harm's way. When will this absurdity cease? How many more of us have to die before things change? What will it take to dismantle the perverse, ridiculous, VVIP culture that disempowers us all?

Fourth, our great institutions of state have become political instruments for taking advantage of us in every way imaginable. Maharashtra, affected by the most vicious act of terrorism yet experienced was held hostage to the political machinations of the Congress and NCP for days before appointing a more capable Chief Minister. Is caste politics emblematic of a 21st century India? And should choices for the Maharashtra CM be confined to a list of the dubious?

Fifth, our political system has now become completely dysfunctional in form and substance. Present political machinery is inherently incapable of delivering good governance no matter how well-intended it might be; which it is not. The senior Mrs. Gandhi's imperial hauteur triggered the end of one great national party. Since her ascension, Congress has become a private family business that no one but the family can run. But family members are not wise, knowledgeable, or capable. If they were, they would not have kept as Home Minister someone who had proved himself so grossly incompetent (though sartorially elegant) time and again, just because he was loyal. They are unable to distinguish between their political interests and those of the country. They live off an unfortunate legacy of involuntary sacrifice. The Nehru-Gandhi dynasty has done some good. But it has also done much harm to India's economy, polity, and the integrity of its social fabric with profoundly mistaken strategic choices. What this family should do now is leave India to find its own feet without them. They could let India dispense with the curse of dynasty and allow what was once a great national party to rebuild itself, so that talent, not heritage and surname, are valued. They could let capable young politicians rather than sycophants kowtowing to the family come to the fore.

But, just as Congress has degenerated into becoming a family firm, the BJP has morphed from various preceding branches of an 'opposition' to Congress to go the communal route; hinting none too subtly that democracy should be replaced with a tyranny of the religious majority. An accompanying trend to the mutation of the two national parties has been the emergence of fractured regional entities posturing as political parties when they have no beliefs, values, or philosophies about economics, politics, social development or governance. But, playing on themes of caste, creed (greed?) and language, such parties have gained local traction. They are the price that India now has to pay in the form of dysfunctional coalition governments in which the national parties provide a platform. The rest represent caste interests (dalits, yadavs, thakurs, gujjars, marathas, brahmins ... the list is endless) or a Marxist Left incapable of learning. They are available to the highest bidder. They need ministerial office for immunity from prosecution and enrich their privy purses. But we have no defence from them.

Sixth, our ability to exert any real political choice and discipline over those who supposedly represent us, when they go astray, has disappeared. Since one political coalition is as venal as the other we have no real choice. Our laws for investigating assets disproportionate to known income as a check on political malfeasance have fallen by the wayside. Indeed no politician cares about being prosecuted for amassing wealth illegally. Many are happy to reveal ill-gotten gains publicly. They are aided and abetted by laws intended to encourage equal opportunity, but instead provide perverse incentives for entrenching the caste system through a pervasive and pernicious system of preferences. In all these ways, we the Indian public, have become complicit in the ethical disintegration and corruption that engulfs us; that makes India a lawless, non-compliant, undisciplined, ungovernable society, in more ways than one.

26-11-08 is a wake up call to all of us that we have let things slide too far. We have tolerated the evolution of a system of misgovernance and a political ethos that is damaging to our lives, and to the integrity of India as a nation. This tragic episode underlines the reality that India has no bright shining role in the world unless it focuses on upgrading radically and immediately the ethics, machinery and institutions of governance in the same way, to the same world standards, that so many Indian corporates have attained in the last two decades.

We all need a state that functions. We need a presidency that commands respect not derision. We need a legislature that works effectively. We need lawmakers who are not our worst, most conspicuous, law-breakers. We need a government that governs well, provides essential public goods like law and order (which no other agent can provide) and caters to our interests. Instead we have a government that does everything but govern, and caters only to the interests of those in government. We need a government whose business is governing, not running businesses. We need a judiciary that delivers justice, not endless delays and the denial of justice. We need a legal system and police forces that function to serve law and order, and not to serve the pecuniary interests of legal professionals and the security of politicians.

This is not as elusive as it sounds. In public service we have some extraordinary people, though they are swimming against the tide in an ocean of mediocrity and incompetence. We do not lack the knowledge or financial resources to make our government work and perform alongside the best governments in the world. What we lack is the political culture and will to make it happen. But we also lack in our desire as citizens to demand the best. Why?

Because: seventh, we are pretty lawless ourselves. We pride ourselves on our individualism to the point where we do not notice how antisocial we are. We take short cuts as a matter of course every day in every way. We seek preferences at every turn, and look for favoured treatment through political connections to employment, promotion, licenses and other forms of advantage. The way we drive on the roads, cross streets, or queue for buses, trains or tickets at a cinema, shows just how unruly and undisciplined we are. We have not yet come to accept what is taken for granted in developed societies: i.e. that laws and rules apply to us in every aspect of our daily lives. They are not applicable only to others. We need to become a law-abiding, compliant society to reduce the frictional losses and transaction costs of selfish and undisciplined behaviour. We need to care not just for ourselves but for our neighbours. We need not to keep just the inside of our home clean while allowing common areas outside to be filthy. We need all these things more urgently than we need anything else to develop and grow. We need them sooner rather than later.

If it were not for our own faults as people and as citizens, our government and polity would not have so many. Nor would we be so tolerant of them. If it were not for our shortcomings, our forces of law and order would not be as pressed as they are in normal circumstances. And if we justified our demands for better security and governance, by improving dramatically our own standards of behaviour, we might eventually get them. It is one thing for others to terrorise us. It is quite another for us to terrorise ourselves on an ongoing basis.

Nightmare at Satyam

The latest news has amplified the focus on the question: will the chairman of the board, B. Ramalinga Raju, resign along with other key staffpersons? This question will have a significant impact upon the conduct of managers of Indian firms in the future. This question will clearly turn on how the owners of Satyam think. Of these, the institutional investors (particularly foreigners) matter the most. The extent to which the Indian legal environment gives them voice is also an important question. As I wrote in my blog post Crisis in Satyam on Sunday:

What would you do with a manager who lost Rs.9,560 crore? I suspect that in most well governed countries, the manager would get sacked. It would be interesting to see (a) What the institutional investors of Satyam think, and (b) How the Indian legal environment deals with this.

Monday, December 22, 2008

Crisis watch, 22 December

TED spread 1.51
S&P 500 returns +0.29%
VIX 44.93
Nikkei 225 (9:02 AM IST) +1.42%
US Financials index +0.86%
ICICI Bank ADR +1.30%
Call rate on 20th 6.55%
Currency futures (9:06 AM IST)47.4325

Sunday, December 21, 2008

Peering into finance in 2009

I have an article in today's Financial Express on this.

Final version of Raghuram Rajan's report

What you may have seen earlier was a draft. The final version has been released. I have updated my India bookshelf.

Crisis at Satyam

The recent fracas about Satyam Computers is a really fascinating story. Satyam (a computer software firm) was about to buy two real estate companies: a listed company named Maytas Infra and an unlisted company named Maytas Properties. They were going to pay roughly $1.6 billion.

This was a troublesome transaction from so many points of view. First, it would deplete the firm of cash. Second, it would mean defocusing the firm away from software towards real estate. Even if diversification into real estate were the goal, there were better acquisition targets around like Unitech. The case for buying these two companies seems to have been influenced by the shares held in the two companies by managers of Satyam.

Sounds bad? The cynic would say corporations make a lot of murky decisions, fumbling thorugh a variety of conflicts of interest. Indeed, all of management seems to be about overcoming agency conflicts. These kinds of malpractices have taken place in India for a long time.

This time, something new happened. A firestorm of protest broke out amongst shareholders -- particularly foreign shareholders -- and the press. The share price of Satyam crashed and the transaction was aborted. Here's the interesting media coverage:

I was reminded of Niall Ferguson's characterisation of democracy and capitalism as two strands of a double helix; both come together to give us well functioning societies. A decade ago, the institutional shareholders would have been clubby PSUs. Without financial globalisation, foreign shareholders would have been missing. Without the free press that India has, the episode would have been buried in the back pages. In the event, India worked well, and Satyam was the cynosure of all attention on these days. On 16 December, there were just 36,000 trades worth Rs.49 crore for SATYAMCOMP on the spot market (i.e. "CM") on NSE. On 17 December, this jumped massively to Rs.1,340 crore off 0.7 million trades.

I think the most interesting questions to ask in this fracas are:

  • What were they thinking?? Why did they do this?
  • Did share prices show some action before the event?
  • How much value was destroyed?
  • What happens next?

Why did they do this?

One of the good approximations that's found in India, to the modern dispersed-shareholding corporation, is Infosys. They have 16.5% promoter shareholding. By these standards, Satyam has a remarkably small promoter shareholding of 8.6%. They have 61.57% shareholding by institutions of which 46.86 is made up by FIIs. There is a large ADR with 19.4% of the company.

With such a power structure, why were the managers so brazen? Did they not know that they serve at the pleasure of investors, particularly institutional investors and most of all foreign institutional investors?

A few days ago, I wrote a blog post Goodbye great moderation, hello financial fraud?. In this I argued that we might see an upsurge of illegal / ethical activities when businessmen have their backs against the wall. This perspective gives us some insight into why the managers of Satyam behaved the way they did.

What do we see in share price data?

A careful examination of share price fluctuations, net of industry index movements, is a valuable tool to understand the information that is available to insiders (who routinely trade or leak information into the Indian equity market). A comparison of Maytas Infra against the CMIE stock market index for industrial construction companies is instructive. From roughly 23 September 2009, the industry index and the overall Cospi dropped quite a bit. But Maytas Infra held up well. Even though things were very bad for Cospi and even worse for the industry index, Maytas Infra stayed put. Perhaps the people trading Maytas Infra knew that they had a `Satyam Put'.

Here's a summary of stock market returns on the products of interest:

Date Satyamcomp Cospi Maytas Infra
31 Oct 304.65 1304.96 429.95
16 Dec 226.55 1367.90 481.15
  Change -25.63% +4.82 +11.91
19 Dec 162.70 1396.43 246.40
  Change-28.18% +2.08% -48.87%

16 December was the last happy day. But by 16th December, while the overall Cospi had gained 4.82% when compared with 31 October, Satyam had already lost 25.63% and Maytas Infra had gained 11.91%.

By 19 December, Satyam had lost another 28.18% and Maytas Infra had lost 48.87%.

Note that the broad market index, Cospi gained in both sub-periods: It went up by 4.82% in the first phase and 2.08% in the second, adding up to overall returns of +7%.

How much value was destroyed?

Let's tote up the value destruction in the three days from 16 to 19 December. All values are in crore rupees.

16 Dec 19 Dec Delta
Maytas Infra 2832 1450 -1381
Satyamcomp 15227 10964 -4262
Total -5644

So in three days, the market value of Satyam dropped by Rs.4262 crore and if you add in the drop in market value of Maytas Infra, this comes to Rs.5,644 crore. But as argued based on the share prices above, the story probably runs deeper and share prices of both companies were in motion based on anticipation of these events prior to this. If we start at 31 October, the picture is:

31 Oct 19 Dec Delta
Maytas Infra 2530 1450 -1080
Satyamcomp 20524 10964 -9560
Total -10640

So over a date range in which the broad market gained 7%, the mistakes made by the managers of Satyamcomp managed to destroy Rs.10,640 crore.

What happens next?

These recent events have already been a path-breaking experience. In India, it is rare for owners to rein in managers in this fashion. But I suspect the story is not over. A few more path-breaking elements of the story might be in store for us.

  • What would you do with a manager who lost Rs.9,560 crore? I suspect that in most well governed countries, the manager would get sacked. It would be interesting to see (a) What the institutional investors of Satyam think, and (b) How the Indian legal environment deals with this. P. Vaidyanathan Iyer's article in Financial Express (linked above) is the first one to mention this possibility.
  • One of the consequences of doing an ADR is that the firm submits to US rules about investor protection. I am curious about the legal position of the managers of Satyam and how that aspect might unfold.
  • The firm is holding a remarkable amount of cash [statement]. Of a balance sheet size of Rs.8,800 crore, cash and bank balance is Rs.4,461 crore. The only reason for a company to keep retained earnings is if it will produce returns that are superior to the broad market index using this cash. If this is not the case, then the board of directors should insist that cash is paid out to shareholders who can atleast invest in an index fund and obtain the performance of the broad market index. It is better for investors to diversify rather than for firms to diversify.

Saturday, December 20, 2008

Difficulties in building highways

The National Highways Authority of India is administering one of the biggest and most important infrastructure projects of India. While in the early years, NHAI introduced important institutional innovations that made good quality highways possible, in recent years, things seem to have gone astray:

Difficulties in building highways matter by themselves since these highways are a powerful transformative force that reshape the economy. These issues are also particularly pertinent when we think of the financial or institutional constraints that impede using fiscal policy to stimulate the economy in the downturn.

Monday, December 15, 2008

Tracking the downturn

I have an article in Financial Express today where I look at recent developments in non food credit of the banking system, non-petroleum imports and non-petroleum exports.

Sunday, December 14, 2008

Goodbye great moderation, hello financial fraud?

The calculations that lead up to fraud

Under normal circumstances, the checks and balances of capitalism work fairly well, particularly in good countries, when it comes to the problems of fraud. This reflects the rational decisions of individuals who compare the benefits from two paths:

Behaviour within the rules
This yields the NPV of cashflow from now until death from being able to work and earn profits in the business.

Breaking the rules
This yields some benefits immediately. There is a certain probability of getting caught and a certain delay in getting caught. Once the person is caught, a punishment is inflicted, and the NPV of cashflow from good behaviour is lost.

The system of checks and balances has been optimised for normal times and, by and large, in good countries, it does a good job of deterring misbehaviour.

Understanding the two big recent blowups

The global economic turbulence changes the balance between these elements. For many people who have their backs against the wall, when faced with imminent disaster in their ordinary business, the payoff to the first option -- behaviour within the rules -- goes down sharply. This increases the temptation of breaking the rules.

I think this is one insight into the disclosures about fraud by Marc S. Dreier [link] and Bernard L. Madoff [link, link].

The Madoff story will inspire some to say that the concept of a hedge fund is fundamentally broken. They will argue that in good times, the checks and balances work out okay, but when volatility is high and some hedge funds have made very large losses, the temptation towards malpractice becomes irresistible, and the lack of hands-on government involvement in hedge funds is a fatal flaw.

The story is a little more complex. A more careful examination shows that both cases (Dreier and Madoff) were a bit out of the ordinary. In the Dreier case, as the NYT article by Alison Leigh Cowan, Charles V. Bagli and William K. Rashbaum says:

Mr. Dreier, 58, controlled the finances of his law firm to an unusual degree, according to lawyers there, because of the unusual way it was set up.
Mr. Dreier was the only equity partner in the firm, and deals were structured so that only he knew all the specifics and had access to all accounts, people with the firm said in court papers. Mr. Dreier convinced lawyers that such an arrangement was best by emphasizing that it would allow them to concentrate on their first love, the law, while he worried about running the firm.
There would be no executive committee. No partners meetings. Mr. Dreier would handle all administrative chores.

Their checks and balances were unusually weak for this organisation, even by the standards of tranquil times.

In Madoff's case, as Roger Ehrenberg says:

Hedge funds, the purported touchstone of the unregulated entity, are far more regulated and subject to many more checks and balances than Madoff every was. I've long made the argument that hedge funds are actually heavily regulated, not directly but indirectly through their relationships with the heavily regulated prime brokers. Forget about the negative PR and spin - it's true. Prime brokers have full transparency into the books of hedge funds, contribute data to the reporting of Net Asset Value (NAV), which is generally pumped out by the hedge funds' administrator. There is a further layer of protection offered by the hedge fund's auditor. Unless everyone is in cahoots it is pretty hard to see how a hedge fund is systematically mis-reporting NAV (except with respect to illiquid assets, but this is another issue entirely). 
Some of the biggest non-market risks of hedge funds include style drift (veering from the strategy outlined in the prospectus, such as when Amaranth's natural gas trades ceased to make it a multi-strategy fund), creeping illiquidy (taking advantage of the illiquid asset carve-out in the prospectus only to see the value of the liquid assets fall, resulting in a prospectus-breaching concentration in illiquids), overuse of side pockets (concentrated, balky public positions that don't fall under the rubric of illiquids yet result in a similar risk profile) and manager fatigue ("If I'm down 50% and it will take me years to dig out from under my high water mark, I'll just shut down"). Note that these risks have to do with the character of the manager, things that a good due diligence process should ferret out. But they really don't have to do with the veracity of the firm's positions, books and records, as third-party involvement together with the regulatory oversight of the prime brokers makes the Madoff kind of fraud highly unlikely.
But Madoff is a completely different kind of firm. It is a broker/dealer with an asset management division, enabling it to rely entirely on itself for trading and settlement. Further, it used a no-name, three-person accounting firm, unheard of for a firm of Madoff's size, scope and complexity. A purely rational trader of Madoff's stature would have set up a hedge fund business to extract 2/20 from his clients. I guess we now understand why; it would have subjected his portfolio to the unwanted scrutiny of his prime brokers. By keeping his game completely in-house and on the down low, it essentially fell through the cracks of our regulatory structure. Will this cause the SEC to redouble its efforts in regulating broker/dealers? Force changes in transparency, similar to what I've pushed for in the OTC derivatives market to the broker/dealer community? Or is it simply a matter of creating rules that ensure credible third-party involvement in the validation of assets under management/NAV in order that Madoff's brand self-dealing couldn't be sustained?
When it comes to client funds, I believe the involvement of multiple third-parties in the validation of positions and NAV is critical. Checks and balances have to be built into the system, and by employing a structural approach to regulation as opposed to simply adding more regulations, I believe we can minimize the friction in the system while providing the necessary protections to individuals and institutions. The lack of trust so pervasive in today's financial markets just took another hit. But let's take a moment to think of the right way to address the issue (better due diligence, higher standards for fiduciaries, imposition of checks and balances with broker/dealers and asset managers working under the same roof), rather than the way that plays best for PR purposes.

In this case also, the checks and balances that prevailed on Madoff's operation were not typical of what is found with the ordinary hedge fund. The Madoff story is not an indictment of the concept of a hedge fund, but a critique of the specific form through which his fund was organised.

Benefits from the involvement of a third party

I see an analogy with the idea of the third-party repo.

A repo is a collateralised loan. You give me a security worth Rs.100 and I give you a loan of Rs.80. As the price of the security fluctuates, marking to market needs to be done to ensure safety. The difference (Rs.20) is called the `haircut'. The size of the haircut is chosen based on the price risk and liquidity risk of the security between two consecutive marks-to-market.

It is possible to organise a repo properly with bilateral credit risk exposures. If both parties were good and efficient, then marking to market of collateral values would take place properly, haircuts would be computed correctly and always maintained. But there is the risk of operational failures or outright fraud. This is where the `third-party repo' greatly improves matters. The borrower and lender do not directly deal with each other: each deals with the 3rd party who supervises the proper functioning of the transaction as time passes.

This helps simply by bringing in a third party into the transaction. It increases the number of people reconciling accounts. But at the same time, if the third party is just an accountant, there is a greater risk of his doing work only on a best efforts basis. What will really bind the incentives of the third party is for him to do netting by novation: for him to be the legal counterparty to both sides. So when X borrows from Y, at a legal level, X borrows from the third-party and the third-party borrows from Y. This ensures incentive compatibility for the third-party who is then much less likely to make mistakes.

An Indian perspective

In India, under normal conditions, blocking fraud is difficult because the probability of being caught is low, the delay in imposing punishment is high, and the punishment is often quite small.
In this backdrop, the events of 2008 have induced massive profits and losses in unexpected places. I suspect some scandals will pop up.

By and large, the world of SEBI, NSE, NSCC, CCIL, BSE, NSDL, CDSL and mutual funds works fairly well in having strong checks and balances. The life of a typical securities firm in connection with these elements of securities infrastructure is tightly integrated into IT systems run from above. These IT systems correspond to a real-time offsite supervision system. They substantially remove room for fraud. While I expect things will work out okay there, there is always the possibility of some chinks in the armour showing up.

The famous scandals of the past are instructive. Harshad Mehta exploited the flaws of the depository for government bonds. Ketan Parekh exploited the weak risk management of Calcutta Stock Exchange. Home Trade exploited the flaws of the settlement system for bonds. Each of these took place in a part of the system where the real-time offsite supervision system described above was absent. That's a fair guide to what might happen in 2009.

Problems are perhaps more likely in the less regulated companies including listed companies. Some firms have a lot of leverage on their balance sheets and some CEOs have a lot of leverage on their personal balance sheets. Some CEOs have personally given buyback promises to institutional investors who got invested in their stock. These individuals are under a lot of pressure. The less ethical of them could buckle under this pressure and resort to breaking the law.

Friday, December 12, 2008

Nandan Nilekani's book

Just so that you know where I'm coming from: The only book by a CEO that I can recall reading was Father, Son and Company, by Thomas J. Watson (which was a wonderful book). And I never read management gurus.

Nandan Nilekani's book is outstanding. Everyone who is interested in India's future should read it. It is by a thinking person for a thinking person; do not get put off by the fact that he's a billionaire. The website associated with the book is also interesting.

I updated my India bookshelf page.

Thursday, December 11, 2008

Does anyone have a post-recession exit strategy?

by Percy Mistry.

[for the Financial Express, November 27th, 2008]

The past was prologue. The present is panic. The future: a conundrum? Banks in every country, along with their industry counterparts, are queuing up for liquidity, capital, or guarantee assistance. "If him, why not me?" Such 'me-too-ism' has triggered a cascade of knee-jerk reactions in governments around the world. The US has a bailout a day. The UK and EU follow a day later. The two giants of the future, India and China, are in on the act. The trend is snowballing downhill and we now have a recession.

Fiscal/monetary expansion in Sep-Oct, 2008 was aimed at averting financial system collapse. In November, it was redirected at preventing global demand collapse. Extolling the lessons of 1929-39, when the global economy was rescued (paradoxically) by a world war, governments seem willing do anything; no matter how unacceptable in 'normal' times (what were those like?) to avert deep, prolonged recession, even a growth recession. Politically and socially, its consequences are unthinkable; especially for administrations (like India's) at a critical juncture in their electoral cycles.

With gargantuan amounts of cash being pumped out, is there a risk of the world later drowning in a flood of worthless money created by well-intentioned public recession-fighters? Will such profligate largesse defer, or prevent from taking place, the adjustments needed to rectify chronic global imbalances in consumption, savings, investment, and borrowing? Policy-makers might regard such questions as misplaced, churlish, or premature. To them, any voice asking right now whether they know what they are doing or overdoing, is a foolish intrusion that will make this recession and financial crisis worse.

Keynes' solution of expanding countercyclical fiscal deficits to combat declines in output had a caveat; that, in boom times, governments must generate fiscal surpluses. Since 2000, most governments have been running large deficits in booms; not least in India. They now want to run even larger deficits to mitigate a bust. The logic seems to be that, since irresponsible government spending and borrowing created this mess in the first place, more reckless government spending and borrowing will get us out of it. Such reasoning may seem sensible to economists armed with theory. It is difficult to explicate to laymen armed only with common sense. That may be why economists are held in the regard they are. If experts think that unrestrained money-pumping will work out in the short and long term, they need to explain why. Perhaps we should be concerned that the experience of 1929-39 taught us what NOT to do in a recession; i.e. tighten the fisc and squeeze money supply. Unfortunately, it did not teach us WHAT to do, or be sure that what we are doing (i.e. the opposite of what was done before) is right. There is no play for this unprecedented scenario that has been rehearsed and worked out.

Looking to governments to solve the problem has dispensed with all concern about privatising profit and socialising cost. Diehard socialists and pompous purveyors of bizarre heterodoxy (suspicious of markets they cannot control directly) are gloating yet distraught. If we probe deep enough, looking to governments to solve the present crisis is not as odd as it seems. Our current predicament is rooted in: (a) prolonged, cavalier irresponsibility of governments - i.e. in irresponsible management of fiscal, monetary, trade, and external accounts (on the part of the US, UK and EU sans Germany), and (b) in self-serving, but globally damaging, exchange rate policies from 2000 to now on the part of China and, a lesser extent, India. The 2008 debacle is not, as populists would have it, rooted exclusively in financial system failure, with excess leverage and risk exacerbated by absurd compensation incentives that skewed the judgement and ethics of the financial community; though there was certainly plenty of that.

Winning the short-term battle of boosting demand and corporate cashflow now seems to be all that matters to former titans of finance and industry. Crisis-induced collapse of demand provides them with a timely excuse to obscure errors of vision, judgement, timing, strategy, and business-model failure. In making billions they believed they were omniscient, omnipotent, invincible, and infallible. Faced with losing billions they want society to bear the cost of their failures. That is the Faustian bargain of mutual assured destruction (MAD) that corporates, governments and consumers have made. So, the notion of taxpayer bailouts of banks and companies may be a tautological nonsense. In the final analysis, the taxpayer (or government on her behalf) is bailing out not banks and firms but herself - in her other avatars as consumer, borrower, depositor, businesswoman, employee, supplier, and producer.

The possibility that victory in the short-term battle of reviving cashflow might result in losing the long-term war of financial responsibility and equilibrium, seems not to matter. To comfort the public that they will do everything in their power to avert prolonged recession, governments are acting in ways that we may not realise the consequences of. The US' serial bailouts have enlarged its fiscal deficit by over 10% of US-GDP. We have not seen the end of them. Adding the UK and EU you get another 8-10% of their GDP. Add others and you have incremental fiscal deficits and incremental net public borrowing piling up to over $5 trillion in the next 1-2 years. This will all need to be borrowed from central banks (risking future inflation) or capital markets where savings are overstretched.

A dramatic shift in risk preference now favours bank deposits and government bonds. But, what happens when that preference shifts to other investments, as it eventually must? Will the shift of all incremental savings into US/EU government debt create stickiness for the eventual recovery of equity markets thereafter? By then the US will owe the rest of the world US$7-8 trillion. What does it mean when the only large reserve currency issuer is the world's largest debtor, sucking in capital from countries that need it more for their own development? Should the world's reserve currency issuer and largest debtor remain exempt from multilateral control, surveillance and guidance when it continues to risk endangering the health and balance of the global economy and financial system?

Likewise, the new liquidity facilities announced by the Fed amount to over US$7.5 trillion; of which US$4 trillion have been used. Those of the EU and other developed countries amount to US$6 trillion. India and China account for yet another US$800 billion. These bloated deficits and liquidity emissions are not trivial. They will have significant future side-effects. Will they succeed in staving off a long and deep recession? We do not know. Will they create post-recession complications that thwart sensible recovery? That likelihood may be higher than it appears now.

After these humongous deficits and liquidity emissions, what strategies will be deployed to bring deficits and money supply back under control; to generate fiscal surpluses and contract liquidity to avoid intractable post-recession inflation? If serious dislocation is to be avoided, and a soft re-entry to normalcy for the world is to be orchestrated, how long will that take? What will it mean for relative growth trajectories in the US, EU, Japan, China, India and other developing countries? What will it imply in terms of achieving essential adjustments: such as the US consuming and borrowing much less, reducing its debt to the world, while saving and investing much more? Will it lead to Europe finally acknowledging the unaffordability, unsustainability, uncompetitiveness, and counter-productivity of its basic economic model: i.e. that of an ever enlarging and intrusive welfare state, increasingly dependent on high-tax but inefficient government intervention to solve every personal/social problem and providing cradle-to-grave insurance, against every contingency? Or will some element of personal responsibility for healthcare, education, and managing personal risk be re-introduced?

Will China be convinced to consume/import more, while exporting, saving and investing less, for global balance to be restored? Will India take the steps necessary to consume, save and invest more, by reducing its fiscal deficit through public asset sales? Will it liberalise its financial system while relieving government of its ownership? Will it transform its labour and land laws/markets? Will it simplify and reform its absurd FDI, FII, NRI capital control regimes to achieve greater efficiency and productivity? Can India and China stave off protectionism by the US and EU by demanding an open global trading regime, while continuing to manage exchange rates (thus preventing adjustment from occurring automatically in global markets) and leaving their capital accounts partially closed? Are open current accounts compatible or congruous with conveniently perforated capital accounts indefinitely?

Such questions may be premature. But are they churlish? The answers may be elusive. So, should these questions not be posed? Indulging in my usual perversity let me ask again: does anyone have a post-recession exit strategy for correcting the fiscal/monetary imbalances we are temporarily but intemperately exacerbating to fight recession? Or have we become so myopic that we are unable to look beyond the next month? If so, the generation just entering the labour market should be seriously afraid about the inter-generational tax and other burdens they are about to inherit involuntarily.

Wednesday, December 10, 2008

Crisis watch, 10 Dec

TED spread 2.15
S&P 500 returns -2.31%
VIX 58.91
Nikkei 225 (9:28 AM IST) +1.92%
US Financials index -5.02%
ICICI Bank ADR -3.33%
Call rate on 8th 5.2601
Currency futures (9:31 AM IST)49.3075
  • Monetary and fiscal policy actions over the weekend. Read my blog post on fiscal, financial and monetary policy responses to the downturn, Ila Patnaik in Indian Express and this editorial in Indian Express.
  • John Gapper on hedge funds going down. The old conventional wisdom was that banks were good and hedge funds were bad. I feel the future is going to have more hedge funds and a smaller role for banks.
  • Consensus on policy issues on credit rating agencies, by Edward Altman, New York University; Kose John, New York University; Harold Bierman, Cornell University; Edward Kane, Boston College; Marshall Blume, University of Pennsylvania; George Kaufman, Loyola University Chicago; Willard Carleton, University of Arizona; Dennis Logue, Dartmouth College; Andrew Chen, Southern Methodist University; Jay Ritter, University of Florida; Tom Copeland, Massachusetts Institute of Technology; Kenneth Scott, Stanford University; Elroy Dimson, London Business School; Lemma W. Senbet, University of Maryland; Franklin Edwards, Columbia University; Jeremy Siegel, University of Pennsylvania; Robert Eisenbeis, Economic Consultant; Chester Spatt, Carnegie Mellon University; Wayne Ferson, University of Southern California; Robert Stambaugh, University of Pennsylvania; Charles Goodhart, London School of Economics; Laura Starks, The University of Texas at Austin; Martin Gruber, New York University; Marti Subrahmanyam, New York University; Lawrence Harris, University of Southern California; Ingo Walter, New York University; Richard Herring, University of Pennsylvania.
  • Avinash Persaud in Financial Express on the fiscal responses to the downturn.
  • An editorial in Financial Express on the Chinese exchange rate regime.
  • Bruce Bartlett in Forbes on What would Keynes do?
  • Larry Summers is going to be a key player in the response to the downturn in the US.

Sunday, December 07, 2008

Policy responses to India's economic slowdown

What might come next in the Indian economy?

India is more integrated into the world economy than ever before. In 2000, goods and services exports were roughly 12% of GDP. Today, they are at roughly twice this number. Gross flows on the BOP (summing across the current account and capital account) were roughly 50% of GDP in 2000. Now they are at 125% of GDP. As these numerical values suggest, the pace of change on India's integration into the world economy has been quite dramatic. This increased integration into the world economy means that global shocks affect India more.

Turning to the global economy, the depth and international co-movement that we are seeing in this business cycle downturn is worse as compared with prior experience.

We are thus faced with an unprecedentedly large shock hitting an unprecedentedly integrated economy. The impact of this external shock will hence be unprecedented. We are in new terrain here. Our intuition has been shaped by the past 20 years. But this intuition is a poor guide to optimal decision making at the level of a firm or the country in the situation that we now face.

What are the channels through which the changed environment impinges on us? The first channel is reduced demand for Indian exports. The second channel is the impact on profitability of many Indian companies owing to lowered prices of their products on the world market. The third channel is the reduced investment owing to the change in animal spirits of CEOs.

Some people are emphasising financing constraints as the channel through which investment could drop. But even before you get to financing, the really important problem is about whether a CEO wants to invest or not. When the future looks difficult, CEOs undertake less investment.

Fluctuations in investment are now the big force shaping the Indian business cycle. Gross capital formation to GDP has jumped from 25% to 38% in a few years. A massive investment buildout is presently underway. Private corporate investment has fluctuated quite a bit with changes of as high as 10 percentage points of GDP in a few years. If expectations become very pessimistic, investment could drop by 5 to 10 percentage points of GDP. This would be a massive shock which would set off a business cycle downturn.

For more on the new forces shaping the Indian business cycle, see my article New issues in macroeconomic policy from last year. You will also find the first chapter `The Economy' of this book to be of interest, particularly Section 1.4.2 titled Perfect Storm?.

In short, the scenario to worry about for calendar 2009 is one where investment drops by a few percentage points of GDP because entrepreneurs are pessimistic about what the future holds.

What can monetary policy do?

The paper The current liquidity crunch in India: Diagnosis and policy response, that Jahangir Aziz, Ila Patnaik and I wrote in early October, frames the questions of monetary policy in the downturn. By and large, RBI has done all the right things on rupee liquidity. Dr. Subbarao did something new and important yesterday when, for the first time, he said that RBI will try to ensure that the call rate stays within the LAF. This will help stabilise the expectations of the bond market about the volatility of the short rate, and thus reduce the fears of banks who were otherwise hoarding liquidity.

With the latest RBI actions layered on top of what they have done in previous weeks, I think the short rate and rupee liquidity are broadly okay. The problem of rupee liquidity is broadly under control.

Monetary policy in India has the power to do damage. If the liquidity tightness of late September had continued, we could have had a run on many or all private banks. Many mutual funds could have experienced acute distress. A broad-based financial crisis could have erupted. These unhappy scenarios have been forestalled by the timely, unorthodox and effective RBI actions.

While bad monetary policy in India can do a lot of damage, there is little room for monetary policy to help counter a business cycle downturn by cutting rates (as is done in mature market economies). The reason for this is the lack of a monetary policy transmission. When the central bank of a mature market economy cuts rates, a complex and sophisticated financial sector takes the `raw material' from the money market and transforms it into enhanced asset prices across a wide range of assets all across the economy. In India, owing to the lack of the `Bond-Currency-Derivatives Nexus', this monetary policy transmission does not take place. The policy rate, expressed in real terms, has gone into negative territory but there is little likelihood of it having a serious impact on aggregate demand. The problem is not a liquidity trap; the problem is the broken monetary policy transmission.

What about the exchange rate, which can be a key element of monetary policy if it's not allowed to float? I think RBI is making some progress on getting away from pegging to the dollar. RBI doesn't release adequate data but my guess is that roughly half of the change in reserves is valuation changes. Many people have focused on the large drop in reserves (measured in USD) as a measure of RBI's attempts at currency trading. But when valuation changes are taken into account, what RBI has been doing there is smaller than it seems [link].

The bottom line is that when the Asian crisis struck, and a business cycle downturn in India was impending, India raised rates (200 bps on 16 January 1998). Exchange rate pegging led to the loss of monetary policy autonomy. This time around, the currency has been allowed to depreciate in exchange for domestic monetary policy autonomy: i.e. lowering interest rates when there is an impending downturn.

What can fiscal policy do?

Can fiscal policy help? I feel this is not the case for two reasons. First, there isn't the fiscal space. Second, the institutional mechanisms through which spending can happen do not exist. I am hence not surprised by the modest aspirations of the recently announced fiscal stimulus. Each percentage point of GDP is Rs.50,000 crore and we are discussing a drop in investment of a few percent of GDP. When it comes to movements of a few percent of GDP, fiscal policy in India is just a spectator.

In terms of automatic stabilisers, there is really only one: corporation tax. In a downturn, corporation tax will drop. At present, it is at roughly 3% of GDP. So perhaps there will be a swing of as much as 1 percent of GDP there. While this is nice in terms of getting countercyclical fiscal policy, it simultaneously makes India's fiscal position look precarious. As an example, this makes it harder for Indian firms to borrow abroad because the Indian sovereign credit rating may worsen in an environment of lower GDP growth and a bigger fiscal deficit. And in this global environment, lenders are much more careful about buying junk (which is where Indian issuers are now).

Summary: the macroeconomic policy response to an impending downturn

The textbook response to an impending downturn is to cut interest rates and enlarge the fiscal deficit.

In the past, the word `business cycle' didn't mean much in India, and macroeconomic policy never tried to do such things. It is an important milestone in India's economic history that we have a weekend in which both monetary and fiscal policy have attempted to respond to business cycle conditions. Stabilisation of the business cycle is one important task of the State in a well functioning mature market economy. We have atleast come to the point where such aspirations are starting to be heard. This is progress.

But in terms of the actual capability to stabilise, a lot is lacking. Long-standing policy blunders, particularly on prevention of a liquid bond market and a liquid currency market, have ensured that India does not have a well functioning Bond-Currency-Derivatives (BCD) Nexus. As a consequence, the monetary policy transmission is weak. As a consequence, the impact of cutting interest rates is small. Mistakes in monetary policy can do damage, and RBI has been doing the right things in helping ensure that it does not do damage. But monetary policy cannot stabilise to a substantial extent.

With fiscal policy also, we are paying for our sins of not reforming. The great business cycle expansion from 2002 onwards should have been a time to put our fiscal house in order. As Vijay Kelkar used to evangelise, the time to fix the roof is when the sun is shining. By today, we should have been holding a GST fully integrated into the Tax Information Network run by NSDL, and we should have had a central fiscal deficit of zero. That would have given us the ability to make large reductions of the GST as counter-cyclical fiscal policy. The right things were not done in the last five years. As a consequence, today, fiscal policy is largely ineffective.

Then what can be done?

A big negative shock is hitting the firms. Some of the firms are fundamentally sound but will require external finance to make it through the downturn. The most important question now is: Can external finance be delivered fast enough and to the right places?

Some of the firms are going to die. There, what would be nicest is if they free up resources gracefully and frictionlessly. By and large, the labour market (that's dominated by the informal sector) works well: firms will shed people, wages will go down, the labour will be absorbed in new places. India has a fairly classical labour market. One key thing we need to do different is to not draft speeches where Indian firms are urged to not sack people; speechwriters should instead be singing paeans to the great flexibility of the Indian economy, that even exceeds the flexibility of the US.

Turning to the assets of weak firms, what is required is good bankruptcy process, or even before that, the control transactions through which brands, factories or companies are sold. To the extent that these control transactions take place, it is best. But for these control transactions to take place, the strong firms require external financing to buy assets.

In calendar 2009 and 2010, economic efficiency will be about the extent to which a discriminating financial system is able to deliver a breath of life of external financing to the good firms (while denying finance to weak firms and encouraging and enabling control transactions for their assets). We should do everything we can to increase the ability of the financial system to play these roles.

The Indian banking system is singularly ill-equipped for this role. In 2009 and 2010, most borrowers will look bad in terms of standard accounting data. Banks in India have a bias in favour of putting investment opportunities in the hands of firms with strong cashflow in historical data. Processes of banks are oriented towards looking back in accounting data and not forward in projecting the outlook for firms. But what will matter the most in 2009 and 2010 is getting working capital and growth capital to good firms which are currently not doing well.

In the big picture, a good financial system is one that is able to deliver low correlations between the cashflow of a firm and the investment of the firm. This issue looms large in thinking about 2009 and 2010. Achieving low correlations between cashflow and investment requires forecasting the prospects of firms instead of looking back at their accounting performance; it requires loans based on future cash-flow rather than loans based on assets. It requires brainpower, organisation culture, and a regulatory environment that is not found in Indian banking. On a horizon like 2009 and 2010 I am pessimistic about achieving change on these things.

Hence, the opportunity for public policy to make a contribution in handling 2009 and 2010 lies in non-banking finance. The positive contribution that policy makers can make towards 2009 and 2010 lie on three directions.

I. Removing capital controls

Removing capital controls will directly augment external financing. By `external' here, I mean financing that is external to the firm. In addition, foreign capital tends to come through more intelligent channels of intermediation such as private equity funds or securities markets, which helps improve the quality of use of this capital.

As an aside, capital inflows will reduce the pressure on RBI to sell reserves if they succumb to currency pegging. But that's not an important issue. The really important issue is to get a financial system that will be able to deliver external financing to good firms in 2009 and 2010.

II. Financial sector reforms

The second direction is the implementation of the Patil, Mistry & Rajan reports, so as to achieve a better functioning financial system.

A few days ago, Tata Motors resorted to borrowing Rs.2000 crore using fixed deposits: i.e. direct deposit taking from households. As Piya Singh points out in The Telegraph, Tata Motors is not alone in doing this. I asked why such a 19th century structure was being used, why it wasn't just a bond issue that was being purchased by households, and the answer was: because regulations interfere with doing an unsecured bond issue.

The right way to organise this transaction is as a bond issue. As an example, in the US, unsecured debt is listed and traded on exchanges. These debentures are issued with face value of $10 or $25, with a 5-8% dividend yield. For Ford and GM, these are trading under $5. Almost all unsecured debt (e.g. AT&T, Sprint, Kraft, etc.) is now available at low prices i.e. high interest rates. Here is an example of bonds issued by GM: their share, the bond and the offer document for this bond. For more on this, go to and type "XGM" into the search box. A household that believes these firms will make it through the downturn can buy this paper. Instead of households doing company deposits, this interaction should be done through public securities markets.

These are the sort of things that can and should be rapidly fixed. We need to urgently get the corporate bond market going, and solve myriad other problems on financial sector regulation, so as to get Finance in shape for performing the roles that are required of it in 2009 and 2010. As an example, there has never been a time when Chapter 7 of Raghuram Rajan's report, on the infrastructure for the credit market, was more important.

The time horizon required to make a big difference on the Bond-Currency-Derivatives Nexus, by implementing the Patil, Mistry and Rajan reports on this subject, is roughly one month. There are no difficulties in these financial reforms in terms of how voters will feel.

III. Economic reforms : the only effective counter-cyclical lever

Given that we do not hold the capability to do counter-cyclical monetary or fiscal policy, what tools for stabilisation do we have? If the root cause of our problem is the animal spirits of CEOs, and the damage that we take on private corporate gross capital formation when they lose confidence, then the most important lever that India has by way of countercyclical policy is : economic reforms. To the extent that domestic and foreign investors think that India is on the right track and that India is doing the right things, the willingness to invest will be greater.

This is both about doing the right things and not doing the wrong things. E.g. we dodged some bullets recently on issues like short selling or shutting down markets after terrorist attacks in Bombay: while wrong policy paths were carefully evaluated, in the end these paths were not taken.

I feel we have to work particularly hard on doing the right things in economic policy reform, for this is the only real countercyclical lever that we control.

It is interesting to look at this in a global perspective. There are $100 trillion of resources worldwide that are trying to get invested, and assets in numerous countries do not look so attractive. Alternatively, look at the world from the viewpoint of an Indian multinational. The prospect of expanding in many other countries is now less appealing than it was last year. In India, in contrast, the deep drivers of growth remain intact. There are very few countries which have the positive long-term growth possibilities of India. The key question is whether the State will do the right things so as to create the enabling framework of public goods to enable and support the rise of a mature market economy. If foreign and domestic investors are persuaded that India is on the right track of market-oriented reforms, investment can come about on a scale enough to matter for business cycle stabilisation.

Friday, December 05, 2008

Crisis watch, 5 December

We get back to our regularly scheduled financial crisis.

TED spread 2.18
S&P 500 returns -2.93%
VIX 63.64
Nikkei 225 (9:31 AM IST) +0.81
US Financials index -2.07%
ICICI Bank ADR +0.36%
Call rate on 4th 6.0995
Currency futures (9:31 AM IST)49.91